← InstitutionalLesson 19 · 4:23
Tail hedging and a convexity budget
Summary
You can explain what a tail hedge is and why a convex hedge pays most in a deep fall. You can compare a far put, a put spread and a ratio by yearly cost against crash gain, explain why a VIX spike must be cashed while it lasts, and set a convexity budget by weighing the calm-year cost against the crash result.
Key terms
- tail hedge
- Protection that pays when prices fall hard, bought to cut the loss in a crash.
- tail
- The rare, far end of what can happen, such as a very large fall.
- convexity
- The shape of a hedge that gains faster and faster as the move grows.
- put spread
- Buying one put and selling a cheaper one further down, which caps both the cost and the payout at a floor.
- ratio spread
- Buying one option and selling two further out, so one sold option is uncovered.
- VIX call
- A call option on the VIX that gains when the VIX rises, paying on volatility itself rather than on a price.
- convexity budget
- A set share of the desk spent each year on protection, chosen by weighing the calm-year cost against the crash result.
- collar
- Owning shares while buying a put below the price for a floor and selling a call above it for a ceiling.
Check yourself
Answer each question to see why the right answer is right.
1. Seven lots of the XYZ book lose $14,871 in the March 2020 replay, against a desk limit of $10,000. What does a tail hedge do here?
2. As XYZ falls and volatility rises, the $80 put barely moves at first, then curves up and gains faster the deeper the fall. What is that called?
3. A year of each hedge (12 monthly) per lot: the $80 put costs $396 and paid $1,524 in the replay; the $88/$78 put spread costs $684 and paid $611; the ratio costs $264. Which statement matches the lesson?
4. You hedge with VIX calls. VIX closed above 38 in early August 2024, then near 18 only eight days later. What does this teach?
5. With an estimated calm-year edge of about $6,600, four puts a month cost $1,584 a year (under 2% of the desk). The book keeps $4,974 in a calm year and loses $8,776 in the crash. Three puts a month still broke the limit. What is the decision?
Finished the video and the quiz? .